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Structured Settlements: Are Factoring and Commuting Different?

By Robert W. Wood, Wood & Porter, San Francisco, CA

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Claimants in personal injury cases often structure their
settlements, choosing periodic payments rather than a lump
sum. If claimants who take a structured settlement later
realize that they need some or all of the funds earlier than
scheduled, they may turn to a factoring company. Factoring
occurs under an agreement between the claimant (i.e., the
payee) and a third party. The payee usually assigns future
payment rights to a factoring company in return for a lump
sum. Subsequently, the payer of the annuity continues making
periodic payments, but to the factoring company.

Factoring companies are not insurance companies, nor do
they issue annuities. However, some insurance companies are
entering the factoring business. If an insurance company
factors periodic payments under an annuity it issued, this
is not factoring, but rather, “commuting.”

Commuting
is similar to factoring, in that the payee receives a lump
sum for giving up future periodic payments. However, in a
commutation, the payee is not paid by a third party. From a
payee’s viewpoint, factoring and commuting both produce
cash, but the factual differences are significant. Although
these two vehicles may both get cash to the payee, it is
unclear whether an insurance company can commute periodic
payments under its own annuity policy and still comply with
Federal income tax law.

Periodic Payments

A structured
settlement begins with a tax-free personal physical injury
or workers’ compensation recovery. The plaintiff may want a
structure to control spending, conserve assets or enhance
eligibility for public benefits. Because structuring a
settlement also makes otherwise-taxable interest tax free,
the tax benefits alone can be enormous.

Mechanically, the defendant assigns its obligation to
make periodic payments (a qualified assignment) to a third
party (the qualified assignee), by paying it a lump sum. The
qualified assignee purchases an annuity to fund the periodic
payments, often from a related insurance company. Although
the qualified assignee receives a lump sum, this payment is
not included in its gross income (up to the purchase price
of the funding annuity), provided several requirements are
met.

Perhaps most important, under Sec.
130(c)(2)(B), the periodic payments cannot be accelerated,
deferred, increased or decreased by the recipient.
Settlement agreements and qualified assignment and annuity
contracts often contain anti-assignment clauses designed to
prohibit payees from assigning rights to receive future
periodic payments to third parties. Although the
enforceability of anti-assignment clauses is beyond this
item’s scope, such clauses typically do not prevent a payee
from factoring, especially if the transfer or assignment is
approved by a court order issued under an applicable state
transfer statute.

Excise Tax

To avoid the excise tax, the
factoring transaction must be approved by a “qualified
order,” defined by Sec. 5891(b)(2) as a final order,
judgment or decree finding that the transfer of
structured-settlement payment rights does not contravene any
statute. (Many state laws also require court orders before
structured settlements can be factored or commuted.) In
addition, the periodic payments must be (1) fixed and
determinable, and not accelerated, deferred, increased or
decreased by the recipient (per Sec. 130(c)(2)(A) and (B));
and (2) payable by a person who is a party to the suit,
agreement or workers’ compensation claim, or by a person who
has assumed the liability for these periodic payments under
a qualified assignment in accordance with Sec.
130.1

Because payments in a factoring
transaction do not change and the annuity remains
outstanding, it is generally accepted that these payments
meet Sec. 130(c)(2)’s requirements. However, when an issuer
commutes its own annuity, it makes no further payments.

From the payee’s perspective, both factoring and
commuting arguably involve acceleration, because in either
event, the payee receives funds earlier than specified. From
the issuer’s perspective, an acceleration arguably occurs
only in a commutation; it continues to make scheduled
annuity payments after a factoring. From the qualified
assignee’s perspective, a commutation is arguably an
acceleration, while factoring is not. The qualified assignee
is the annuity’s legal owner and has the right and power to
change its terms.

Timing

Another matter is
timing. If Sec. 130 was met when the structured settlement
was entered into, subsequent factoring does not affect it
(i.e., the qualified assignee’s Sec. 130 tax break is not
affected by later factoring). It is unclear whether a
subsequent commutation fares as well. Even if a commutation
does not trigger an excise tax, an “acceleration” could
violate Sec. 130, particularly if the time between issuance
and commutation is minimal.

For example, if an
issuer commutes an annuity in close proximity to the
qualified assignment, it might be deemed to have had a
prearranged plan to commute. If it contacts all payees
receiving periodic payments and actually solicits the
commutation of its own annuities, this could conceivably
invoke constructive-receipt issues for payees, even if they
must meet some requirement to receive the money.

Of
course, focusing unduly on timing should not obscure the
fact that any acceleration (increase, deferral,
etc.) is contrary to Sec. 130. Still, if an insurance
company offers to issue structured-settlement annuities and
simultaneously seeks to commute them, is the commutation
bona fide (even without an express link between a particular
issuance and a particular commutation)? It seems hard to
reconcile this with Sec. 130’s “no acceleration”
mandate.

Court Order Ramifications

To avoid
the excise tax, an acquirer of structured-settlement payment
rights must obtain a final order, judgment or decree of a
state court or responsible administrative authority ruling
that the transfer-of-payment rights do not contravene any
Federal or state statute, or the order of any court or
responsible administrative authority. Under Sec. 5891(b)(5),
this qualified order is “dispositive” for purposes of
avoiding the excise tax.

Although such an order
plainly means no excise tax, it probably means no more than
that. Under traditional Federal income tax principles, a
ruling by a state or Federal court is not binding on the
Service or the courts.2When trial courts rule
that a payment has particular tax consequences, the IRS
often disagrees.3 Even a trial court’s ostensibly
factual findings (e.g., that a plaintiff’s recovery is for
personal physical injuries) are not binding on the Service
or the courts.4 A court ruling that no statute is
violated—a precondition to avoiding the excise tax—surely
cannot, by itself, determine for Federal tax purposes that
an assignment qualifies under Sec. 130.

Conclusion

Although the Code appears to permit
factoring, there is no clear answer as to whether annuity
issuers can commute payments due under their own policies
without adverse tax consequences. Considering Sec. 130’s ban
on acceleration, deferral, increase and decrease, factoring
and commuting seem different. Factoring does not violate
these four requirements, while commuting seems to.

If issuers risk violating Sec. 130 when they commute
their own annuities (with or without a qualified order under
Sec. 5891), the consequences could be quite severe. Without
Sec. 130, the assignment company could face a crushing tax
mismatch, paying tax on the initial payment it receives to
fund the annuity, but deducting payments to the payee only
over time. Until this issue is clarified, this is a risk
that seems too big to take.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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